A Smart Solution to the Net-Tax Issue

December 11, 2003

By Christopher Farrell I'm behind on my holiday shopping. So it's a safe bet I'll spend some time online over the next few days buying gifts for family and friends. I'm far from alone. Forrester Research, the high-tech consulting firm, estimates online sales during the holiday season will be 42% higher this year compared to last. The spread of broadband and wireless Internet access is making it easier than ever to surf the Web for gifts from the comfort of the office or home.

Shopping online is convenient. But it has state and local government officials upset because they're not collecting sales tax on cyber transactions. The state and local tax revenue loss from e-commerce could total $55 billion in 2011, calculate professors Donald Bruce and William Fox for the Center for Business & Economic Research at the University of Tennessee. Translated into percentage terms, they project that the states stand to lose 2.6% to 9.9% of tax revenues to e-commerce in 2011.

YAWNING FISCAL DEFICITS. Taxing online commerce is a contentious issue. Congress gave Web outfits a safe harbor from taxation to encourage the spread of a new technology. But state and local government officials are lobbying to end the moratorium in exchange for simplifying and streamlining the state sales-tax system (see BW Online, 12/1/03, "Net Taxes: Here Comes a Battle Royal").

The reason is understandable. These officials have painfully grappled with closing yawning fiscal deficits for the past three years. Despite a strengthening economy, governors and legislatures face another round of contentious budget cuts and tax increases this fiscal year.

Here's a better idea: Hal Varian, economist at the University of California, Berkeley, and a leading information-economy theorist, advocates getting rid of the sales tax altogether. He told the Advisory Commission on Electronic Commerce in 1999, a commission created by Congress to study Internet taxation: "I propose eliminating all state and local sales taxes and replacing them with a revenue-equivalent income or consumption tax." (Consumption tax, often collected in the same way as income tax, isn't levied at the time of purchase. The amount is calculated, by one method, on any income that hasn't been invested or saved.) "The current state sales-tax system is costly, inefficient, and inappropriate for the information age," says Varian.

"INVISIBLE" TAX. No kidding. The U.S. sales tax dates back to the Great Depression when beleaguered governments desperately needed revenue. They like the sales tax because it's relatively invisible compared to property taxes and income taxes. The state simply adds a few pennies or dollars on to a bill you're already paying.

However, the sales tax is riddled with exemptions and doesn't make much sense. For instance, in New York, Kool-Aid is taxable but Ovaltine isn't, according to a study by Governing magazine. Candied apples get taxed but not pretzels. Mouthwash labeled as antiseptic is exempt in some states but not in others. Go figure. Even more important, service businesses like accountants, lawyers, and landscapers don't charge any sales tax. Many states also exempt groceries.

It's also annoying and illogical that even as state and local governments push to charge a sales tax on online purchases, political leaders are rushing to set up trade barriers to protect local businesses from Net-based competition. For instance, car buyers can go online and research automobiles. But state laws bar consumers from purchasing directly from auto makers. You have to go through a dealer. Why? Many states have instituted bans on buying wine, contact lenses, and other goods and services online.

These regulations protect politically powerful local middleman at the expense of consumers. The Public Policy Institute estimates that American consumers pay "a minimum of $15 billion annually more for goods and services as a result of such e-commerce protectionism."

MINIMAL SWITCHING COSTS. State and local government officials really should concentrate on eliminating barriers to Internet-based trade before they even consider charging a sales tax. In the meantime, they could consider alternatives to the sales tax system altogether.

I like Varian's main proposal: Get rid of the sales tax, and hike state personal income taxes to raise roughly the same revenue. Whether it be a new levy on income or consumption, the creation and compliance costs of shifting collection would be minimal since the infrastructure for collecting income taxes is already in place. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online